Sunday, March 04, 2012
12:00:23 PM EDT

Any Price Correction Will Probably Be Minor

by
Gregory Clay

Market Summary
The major stock indexes basically finished flat this week as prices appear to be consolidating at recent highs. Technically, this consolidation is considered a bullish sign as prices are expected to continue in the direction of the current trend. Recent Couch Potato articles have enumerated a myriad of reasons why stocks can be expected to head higher. In the near term, probably one of the best reasons to believe the market will continue to grind higher is because there appears to be a healthy dose of skepticism about the staying power of the current trend. We mentioned how technical stock indicators suggest that prices are overbought. Many investors are viewing the overbought conditions as a rationale to be cautious about the potential for a pending price correction. We are not seeing what would be considered a "topping action" where investors are "all in" and frantically bidding prices higher and higher. The absence of this topping action should be considered a good omen for the bulls as it probably suggest that any price correction will probably be minor.

The February 13th Couch Potato published a March expiration SPY bear call spread
The call spread is approx. $400 in the black (see tables below)
$139 strike price short call delta is .2615 (73% probability this position will be profitable)

The February 13th Couch Potato published a March expiration SPY bull put spread
The put spread is approx. $400 in the black (see tables below)
$129 strike price short put delta is -.0665 (93% probability this position will be profitable)

SPY Risk Analysis
The near term trend is still bullish and unless a correction materializes the continued upward price move could threaten the $139 strike price short call.

The February 22nd Couch Potato published a March expiration DIA bear call spread
The call spread is approx. $400 in the black (see tables below)
$131 strike price short call delta is .3043 (70% probability this position will be profitable)

DIA Risk Analysis
We have not had the opportunity to open a DIA put spread, therefore the only risk is price continuing to move up and threatening the $131 strike price short call.

Exit Plan
As with initiating the trade, the decision process for exiting our SPY and DIA spreads:

Anytime the market maker is willing to accept a limit price of less than .11 on one of our short strikes, buy back all the short contracts and sell the long positions on the same spread. However, if it is a few days prior to the expiration date, we may be able to hold out for a .05 bid.

If one of our short strikes is penetrated (closing price above our short call or below the short put) AND the delta rises to .65 we will look to close out this spread (buy the short contracts, sell the long) and roll it out to another short strike price. Unless this is option expiration week, do not panic and rush to close the trade, many times the market will reverse itself and remove the sense of urgency. If one of our short strikes has been violated and there is no price reversal, we cut our losses and live to fight another day.

Exiting this position prior to expiration we will probably â€œleg outâ€ of each trade by first unwinding either the bear call spread or the bull put spread; and close out the other side of the spread as a separate order. The timing of closing out each side of the Iron Condor is dependent on following our Exit Rules described above.

Final Comment
The February 26th Couch Potato mentioned "...The CBOE Volatility Index (VIX) continues to contract and currently sits at 17.31. This is the lowest level since last summer and indicates that traders are not anticipating drastic price movement...The major concern at this point is with the VIX at such a low point and stocks at lofty levels, eventually a correction will happen. The question is when will prices correct and will it be a minor or major correction..." As confirmed in the chart below the VIX remains subdued. The concern with trading credit spreads in this environment is that lower levels of fear equate to less premium we receive when selling short contracts. Ideally, we would like to execute both call and put credit spreads to hedge the risk. The February 26th article also said "... A slight price pullback would be ideal as this might setup the opportunity to better manage our risks by executing both call and put spreads..."

Gregory Clay

Couch Potato Trader Disclaimer
All results reported in this section are hypothetical. While the numbers represented here may have been achieved or beaten by our readers, we make no representation that any individual investor achieved these exact results. The tracking for the plays listed in this section uses closing prices for the day the newsletter is published and it is not meant to imply that any reader actually received those prices (though many often do) or participated in these recommendations (even though many do). The portfolio represented here is hypothetical and for investment education purposes only. It is only an illustration of what type of gains a knowledgeable trader might receive utilizing these strategies. If you don't get close to these results, guess what. It isn't the fault of the strategies.